What Is NGDP?

By

Kelly Evans

Oct 27, 2011 8:00 am ET

Desperate times call for desperate measures. This helps explain why nominal gross domestic product — that is, total GDP without inflation stripped out – has wound up at the center of a debate over how, and whether, the Federal Reserve can do more to stimulate the U.S. economy and lower the nation’s current 9.1% unemployment rate.

The problem boils down to the Fed’s current dual – or in fact, triple – mandate from Congress. Here is the entire wording of the Fed’s mandate, which falls under Section 2A of the Federal Reserve Act.

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

It is this last part which is at the heart of today’s policy debate. In theory, and in the long run, it should be consistent for the Fed to conduct monetary policy in a way that promotes a healthy economy marked by maximum employment, stable prices, and moderate long-term interest rates. But that is little help at a time like now, when the Fed is roughly meeting the latter two objectives but falling well short on the first; that is, on reaching anything close to “maximum” or full employment, typically defined as something like an unemployment rate of 5% (though many think today, for various reasons including demographic ones, this rate is now closer to 7%).

This kind of dual mandate is pretty unique in central banking. Elsewhere, in Europe and Canada, for example, central banks have a single mandate to promote price stability; that is, to keep the consumer-price level growing at about a 1-2% pace per year, as many have interpreted this mandate. This approach is favored by inflation and deficit hawks who fear the Fed would otherwise monetize government deficits and run the risk of hyperinflation.

Until recently the most vocal opponents of the Fed came from this camp, and there are plenty of economists and Fed officials who would prefer this type of single mandate. (Dallas Fed President Richard Fisher, for one, who earlier this year said “it would not break my heart to have a single mandate” focused solely on inflation and suggested it was up to Congress now to change the wording of the Federal Reserve Act as such.)

Lately, though, as the economic recovery continues to disappoint and unemployment remains stubbornly high, a different group has come to the fore. This camp says that if the Fed is falling short on its “maximum employment” mandate, then it ought to be – it is, in fact, required to be – far more aggressive in stimulating the economy to try and get there.

Consider Chicago Fed President Charles Evans, who in a speech earlier this month said “given how badly we are doing on our employment mandate, we need to be willing to take a risk on inflation going modestly higher in the short run.” He would prefer the Fed to commit to “keep short-term rates at zero until either the unemployment rate goes below 7 percent or the outlook for inflation over the medium term goes above 3 percent.”

Trouble is, this essentially leaves the Fed in the same, difficult position as it is in today. Hence calls, which are growing ever louder, for an entirely new, different kind of target: nominal GDP. This is something Scott Sumner, an economist at Bentley University whose views have gained prominence through his blog, TheMoneyIllusion, has been pushing for two decades. His support base among academics lately has been growing. And perhaps most significant, since it suggests the Fed might actually be open to such an idea, is that Goldman Sachs economists have just endorsed the idea as well.

The version which Goldman puts forth, building on the ideas of Sumner and others, is that the Fed ought to aim for a specific level of NGDP which would put the economy back on the trend it was prior to the recession; to close, in other words, the current gap between the economy today and where econometric models suggest the economy should be. This is no small gap; Goldman estimates the shortfall, as of the second quarter, is roughly 10%. To most quickly close this gap, Goldman estimates the Fed would need to roughly double its balance sheet to $5 trillion and keep interest rates at zero through at least 2016.

The beauty of the NGDP target, as proponents see it, is that it doesn’t differentiate between inflation and real GDP. So it doesn’t matter whether the gap is closed by three parts inflation and one part real GDP or one part inflation and three parts real GDP. The point is that the gap gets closed, because the Fed is able to be as aggressive as it needs to be, and the economy avoids a prolonged slump and chronically high unemployment a la the Great Depression. And by targeting NGDP, or a stated goal for the total size of the economy, instead of a 3% or 5% inflation rate, the Fed is better able to avoid the backlash that might otherwise undermine its ability to achieve said objective.

But would this really work? Now that NGDP is getting serious attention, this question becomes all the more important. Below, a (very abbreviated) round-up of the debate. Best to get up to speed as much as possible now, as it is only likely to gain momentum from here.

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